Upcoming TV Appearance

Ron Heller will be a guest on Fox Business Network’s “Countdown to the Closing Bell” on Tuesday, January 27th at 3:45pm ET.

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Upcoming TV Appearance

Tim Gramatovich will be a guest on Bloomberg’s “Market Makers” on Friday, January 30th, at 10am ET, to discuss the energy markets.

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Upcoming Conference

Ron Heller will be in attendance at the TD Ameritrade 2015 National Conference, in San Diego, CA from January 28th to January 30th. Stop by booth #S8 to learn more about Peritus’ strategy and products.

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Canada’s Surprise Interest Rate Move

The Bank of Canada surprised markets today by cutting rates.  With a Federal election approaching, an argument could certainly be made for some political angling.  Regardless, the reaction of the Canadian dollar was swift and immediate, plunging almost 1.5 cents against the greenback.  The Eastern provinces focused on manufacturing benefit from a very weak C$, as it boosts competitiveness in the export markets.  Importantly, the oil industry also benefits as they are receiving primarily US dollars for selling oil, against Canadian dollar expenses, helping to improve profit margins.  This, along with tight differentials for heavy oil (referring to the price of WCS, Western Canadian Select, a heavier grade of crude oil, versus WTI, or West Texas Intermediate), provide some powerful offsets to crude’s pricing implosion and we expect will benefit many Canadian oil producers, an area of the market in which we have been strategically positioned.  At some point, we believe that oil prices will stabilize and these fundamentals will be recognized and rewarded.

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High Yield Bonds versus Equities

Investors are often led down the path that they must invest in equities in order to generate a decent return, and that the high yield market is too risky and speculative.  However, reality and the data points suggest otherwise.  Looking over the past couple decades and various periods in between, you can see that high yield has outperformed the equity market (as measured by the S&P 500 Index) on a risk adjusted basis (return/risk) over the past 5, 10, 15 and 25 years, and performed equivalently over the last 3 years.1

Blog 1-21-15b

Blog 1-21-15c

Here, risk is defined as standard deviation, or volatility of returns.  Even taking into account the enormous technology and internet rallies of the late 1990’s, high yield bonds have performed only slightly lower than equities over the past 25 years, but with nearly half of the risk (standard deviation), for a significant risk adjusted outperformance.3

 

HY substitute for equities2

Looking at that “riskiness” of the high yield asset class in another way, investors need to remember that in a company’s capital structure, equities fall below bonds, no matter the bond rating (investment grade or high yield).  This means that in any sort of difficult situation, the bonds get paid back first.  Further, as the data above shows, high yield bonds have much lower risk as measured by volatility (annualized standard deviation), giving high yield bonds what we see as a significant return/risk advantage.

The data speaks for itself: it seems to be time for investors to reconsider their sizable allocations to the equity market and instead, consider an increased allocation to the high yield bond market.  We believe that the compelling historical long-term returns profile and lower risk (volatility) relative to equities warrants investors paying more attention to the high yield asset class and that it supports the argument that high yield should be a core part of an investment portfolio, especially in today’s low-yielding environment. And with the advent of high yield exchange traded funds, accessing the high yield market is now available to retail and institutional investors alike.

 

1Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High Yield-Annual Review,” J.P. Morgan North American High Yield Research, December 29, 2014, p. A144. “High Yield Bonds” as represented by the JPMorgan High Yield Bond Index, which consists of fixed income securities with a maximum credit rating of BB+ or Ba1.
2 Sharpe ratio consists of annualized returns divided by the annualized standard deviation of return.
3 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High-Yield Annual Review.” J.P. Morgan, North American High Yield and Leveraged Loan Research. December 29, 2014, p. 123.

 

 

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The Year Ahead: High Yield, Energy, and Interest Rates

2014 will go down as a year that was a “statistical champion” as both stocks (as measured by the S&P 500 and the Dow Industrials) and bonds (the more interest rate sensitive asset classes) had very good years. It was a year of duration over credit. What we mean is that interest rate sensitive sectors (Treasuries, mortgages and investment grade) dominated, while credit (high yield bonds and loans) were beaten down. At the beginning of 2014, we were one of the few firms calling for flat to lower rates, but even we did not see an 80 basis point move down in the 10-year Treasury.

So where does that leave us as we head into 2015? Stocks look extended. They are not cheap by any measure but the party continues until it doesn’t. How about bonds? Wholesale selling of the high yield asset class due to its large exposure to the energy industry has created what we see as attractive entry points into numerous names that have nothing to do with the energy markets. We did not see these types of discounts going into 2014. While we don’t expect interest rates to rise much in 2015, they are unlikely to fall and become a tailwind for longer duration asset classes, such as investment grade bonds. Read more of our piece, “The Year Ahead: High Yield, Energy, and Interest Rates,” click here.

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Upcoming TV Appearance

Tim Gramatovich will be a guest on Business News Network’s (BNN) “Business Day” on Monday, January 12th at 2:45pm ET and Bloomberg’s “Street Smart” on Monday, January 12th at 3:45pm, where he’ll discuss his outlook on the energy markets.

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Upcoming TV Appearance

Tim Gramatovich will be a guest on Fox Business Network’s “Opening Bell” on Monday, January 5th at 9:10am ET, to discuss his outlook for energy in 2015.

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Intentional About Energy

As we have discussed in our recent writings, we have been strategically allocated to the energy sector in our portfolios and, as such, have been hit by the decline in energy prices, as well as general high yield market contagion, with the meltdown in energy exploration and production (E&P) credits spreading to the overall high yield and loan markets.  We believe that in today’s broader high yield market we are now seeing a disconnect between fundamentals and pricing and that disconnect has created what we see as an attractive entry point into the high yield asset class.

We have been and continue to be strategically positioned in the oil and gas industry, and that positioning has and continues to be very intentional.  While oil prices have fallen below $60 per barrel for the time being, we believe prices below $80 are unsustainable and have provided chapter and verse as to why (see our piece, “Rome Is Burning”).  Simply put, costs of unconventional oil (where the production growth actually is) are high and returns must be there for production to continue.  This includes certain tight oil plays (i.e., US shale producers), along with deepwater and oilsands.  There is limited growth in production globally outside of these areas.  The Saudis know this and will keep the heat on.

We believe that the law of unintended consequences may ultimately lead to a collapse in production not only from the US, but Venezuela, Libya and Nigeria as well.  For instance, just last week, Libya announced that infighting within the country causing the closure of two of the largest ports has led to a significant decline in production.  The world is not as well supplied as many believe.  Thus we would foresee that as production/supply takes a hit, this could lead to a dramatic rebound in oil prices on a supply/demand imbalance, as we continue to see growing global oil demand needs.

Turning to the US, domestic shale producers who are levered are experiencing bond price declines in some cases of up to 30-50% over the past couple months.  We are not invested in these US shale producers, as we believe that defaults will be real and recoveries may be minimal for many investors.  Many of these “businesses” have huge decline rates, we’ve seen reports that in some cases they can even be upwards of 70% per year; thus we would view them more akin to “projects” than real, sustainable businesses.  Even prior to the oil price decline, it was our opinion that these basins will be drilled out and start declining in the next few years, and with current price points we would expect decline that may well accelerate.

These huge decline rates in shale matter because it means that large capital spending, and equity and debt financing to fund that spending, is required to keep production steady at best in many cases.  While other players in the space, such as the oilsands producers up in Canada, have the ability to meaningfully cut back on capital expenditures and conserve cash during these periods of low oil prices, without taking a massive hit on the product front, we don’t see this same ability with many shale producers, which can quickly lead to a downward spiral for both the bonds and equities in these companies.

We have very specific energy themes, such as focusing on Canadian producers, service providers, and midstream companies, and have been very intentional as to what we hold and why we hold it.  Looking at the general high yield space, at over 16% of the high yield index, energy is the single biggest industry by a factor of two (healthcare is just over 8% of the high yield index)1 and must be dealt with by income-focused investors whether that is through high yield markets or MLPs (master limited partnerships), which also tend to have large exposure to energy.  Investors need to understand what is underneath the energy exposure they do have.

 

1 Based on the J.P. Morgan US High Yield Index.  Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Credit Strategy Weekly Update.”  J.P. Morgan, North American High Yield and Leveraged Loan Research, December 12, 2014, p. 42.
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Upcoming TV Appearance

Tim Gramatovich will be a guest on Bloomberg’s TV’s “Market Makers” on Tuesday, December 30th at 3:30pm ET.

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